Chapter 11 Plan of Reorganization 3: Resolving Debts

“There’s more to resolving business debts than you may think!
Resolving business debts is the centerpiece of your business’s Chapter 11Plan of Reorganization. The Code identifies your business debts by class. Also, it then specifies the entitlement for each class. This article explains what you need to know about resolving business debts under Chapter 11.

How does Chapter 11 resolve business debts?

It’s all in the Code.

The Bankruptcy Code (the “Code”) sorts debts into “classes” and prescribes a specific order (a/k/a “Priority Order”) for resolving them. In addition, the Code specifies detailed rules that govern the treatment of creditors’ claims. And it establishes methods for determining the amounts each class is entitled to receive.

How much income must my business give to settling its debts?

“Owed” Vs “Allowable” or “Entitlement” Vs “Settlement” Vs “Discharge”

“Owed” is the amount of unpaid debt due the creditor. However, in some instances, the Code may only “allow” or “entitle” a creditor to claim something less than the amount owed to them. And yet, the business-debtor and creditor may agree to an entirely different amount as “settlement” of the creditor’s claim. Lastly, a confirmed Plan of Reorganization may settle general unsecured debt for “pennies on the dollar.” Or in some cases, nothing at all. The court will “discharge” (cancel) the remaining unpaid portion of debt.

What the general unsecured creditors get depends on the business’s disposable income.

100% of “disposable income”

The Code requires all “disposable income” to be paid into the Plan. In turn, the Plan distributes the proceeds to the unsecured creditors until they receive all they are entitled to. Typically, it takes three to five years of payments to resolve your business’s debts.

What does the Code mean by “disposable income?”

“Net Operating Profit”

In Part 2 of this series, you calculated a projected Net Operating Profit for the first year of your reorganized business. That result included all the costs for running your business. But it did not include other sources of income, taxes, or repayment of any of the business’s debts.

“Net Profit”

Net Profit equals the Net Operating Profit PLUS:

  • Income received from subsidiary businesses, and
  • Unrelated investment income and unrelated business income, net of expenses

“Disposable Income”

Disposable income is the Net Profit minus federal, state, and local income Taxes. This is the primary source for settling business debts.

How and where does my business project its disposable income?

The Plan of Reorganization

Your business will propose a Plan of Reorganization to the creditors and the court. It shows how the business intends to resolve its debts and settle the claims of its creditors.

Consequently, the Plan must include a Financial Projection showing…

  • projected annual disposable income for the next three to five years, based on realistic assumptions, AND
  • the payments unsecured creditors/claimants should receive each year, AND
  • Disposable income will be sufficient so the business can reliably complete all Plan payments.

How can a bankrupt business afford to settle its debts?

Five sources of funds to settle business debts

A bankrupt small business has five potential sources of funds for resolving business debts:

  1. Cash on hand in the business but there is rarely enough to pay off anything
  2. Cash contributed to the business by its owner(s) (a/k/a “Additional Contributed Capital”). If this is a meaningful source of funds, there wouldn’t be a need for bankruptcy.
  3. “DIP Loans” are a commonly used source of funds. But these loans can only be used for restricted purposes. They cannot be used to repay pre-petition debt unless the court grants an exception.
  4. “Exit Loans” are used to repay a variety of claims and debts upon Plan confirmation. These are “high-cost” loans that require the court’s pre-approval before finalizing them.
  5. Disposable Income is the primary source of funds for making payments to the general, unsecured creditors.

There is one additional source that may resolve debt: the court. Your business can ask the court to discharge (cancel) all or a portion of its unsecured debt. The court may agree if all Plan confirmation requirements are satisfied.

What if there is no available disposable income for resolving business debts?

Chapter 11 is an opportunity to return to profitability and settle business debts

A business files for Chapter 11 because its Net Profit is negative (or negligible) and has no disposable income.

Chapter 11 gives a troubled business the opportunity to reorganize itself and return to profitability. A large part of this opportunity comes from the “Automatic Stay.”

The Automatic Stay gives the business a period of time free of pressure from creditors and collection agencies. The period is 90 days for a Subchapter V filing and 180 days for a Small Business Case filing. The court may grant an extension of these periods. But it will do so only for compelling reasons.

During this period, the business continues operating and using its property. And it does so without the threat of foreclosure, repossession, eviction, or utility shut offs.

However, the business must use this time period to accomplish all three of the following key objectives:

  1. Identify the cause(s) of its unprofitable operations,
  2. Develop and implement a realistic, achievable plan to fix the problems and restore profitability,
  3. Determine how best to resolve its debts and the amount of disposable income available to settle its debts.

Your business must present a “Plan of Reorganization” to the court on or before the end of this period. The Plan includes the changes it will make to its operations and how these changes will restore net profits. And it must include a realistic financial projection. The projection must show sufficient projected disposable income to complete all payments promised to creditors in the Plan.

Also, the Plan must generate sufficient disposable income to pay creditors at least as much as they would under a Chapter 7 liquidation. Otherwise, the bankruptcy petition will be denied. In that case, your business faces termination and liquidation under Chapter 7.

Isn’t resolving business debts simply a matter of my business paying who it can, what it can, when it can?

The Code specifies how your business must address each class of debt.

NO! Chapter 11 prescribes strict rules governing your business’s use of cash, credit, paying expenses and paying off debts. These rules protect creditor and claimant rights. Also, they ensure an orderly process for resolving business debts fairly and equitably. We will cover these rules and more, including …

  • How debts and claims are sorted into “classes” and “Priority Order” prescribed by the Code,
  • The class-specific rules to follow in resolving business debts and claims for each class,
  • How to determine each class’s entitlement,
  • Understanding your business’s options when resolving business debt for each class
  • Choosing the “right” option to resolve the debts and claims of each class

Doesn’t my business resolve all debts equally?

Four classes of debts/claims – each with unique entitlements

The U.S. Bankruptcy Code groups creditors’ claims into four major “classes” (categories). In addition, the Code establishes a priority order (a “pecking order”) for resolving business debts and claims. We will discuss each class in subsequent parts of this series. Here is the priority order, from highest to lowest, of the Chapter 11 Debt/Claim classes.

CLASS I
Secured Creditors, Executory Contracts, and Unexpired Leases
Secured Creditors

Secured Creditors have a lien on debtor-owned property (collateral) that secures these loans. Creditors can foreclose on the loan and seize the property if the debtor defaults on the loan. 

The Code entitles Secured Debt Creditors to the lesser of the amount of debt owed and the Fair Market Value (FMV) of the collateralized property. As a result, the creditor will suffer a loss if the FMV is less than the amount of debt owed (a/k/a “under-secured”).

Executory Contracts

Executory Contracts are agreements for services provided to the business or by the business.

The Code entitles claimants that provided services to the business to keep any security deposit they are holding, up to the amount of the delinquent payments. Claimants on a contract for services from the business debtor may recover pre-payments made for services not yet provided.

Unexpired Leases

Unexpired Leases are rental agreements for the business debtor’s use of property owned by a lessor.

Unexpired Lease claimants keep any security deposits they are holding up to the amount of the delinquent payments. In addition, the leaseholder can repossess the property or evict the debtor from the property.

NOTE: In each of the above instances, the claimant may file a general unsecured claim for any unrecovered portion of the debt owed to them. This is in addition to the “entitlement” portion of their claim described above.

CLASS II
Administrative Expenses and Priority Claims

Administrative Expenses and Priority Claims are specifically identified in the Code.

Administrative Expenses

Administrative Expenses are those necessary for the business to continue its routine operations during the bankruptcy case proceedings.

The Code limits these expenses to those incurred after the bankruptcy petition is filed, and before confirmation of the Plan of Reorganization. U.S. Bankruptcy Code Section 503 explains the recognized Administrative Expenses

Priority Claims

Priority Unsecured Claims are pre- and post-petition statutory and court-awarded obligations. Examples include, accrued wages, pension contributions, domestic support obligations, taxes, etc. U.S. Bankruptcy Code Section 507 provides a complete list and explanations of recognized Priority Claims.

The Code entitles Administrative and Priority Unsecured Claims to 100% of the amount owed to them.

Your business must settle, in full, non-tax-related Administrative and Priority claims on or before Plan confirmation. On the other hand, your business can settle tax-related claims over time upon agreement with the taxing authority. However, your business must submit the written settlement agreement with the taxing authority to the court with the Plan of Reorganization or shortly thereafter.

CLASS III
General Unsecured Creditors

General Unsecured Creditors are NOT protected with a lien on business-owned property. Instead, these creditors rely on nothing more than the business-debtor’s promise to repay the loans. Examples of unsecured debts include credit cards, revolving loans, personal loans, etc. This is the lowest creditor class on the totem pole (but there is still one class below them).

General Unsecured Creditors submit claims for the debt owed to them.  However, typically, the business-debtor will not have enough disposable income going forward to pay these creditors in full. As a result, the business-debtor often can only repay a part of what it owes them, if anything at all.

CLASS IV
Equity Interest Holders

Equity Interest Holders are the business owners. This is the lowest class in the Code’s priority order.

The “Absolute Priority Rule” applies in cases other than Subchapter V. Under this rule, business owners get nothing if the classes above them will receive less than their entitlement. And “nothing” means just that: NOTHING. They don’t even get to keep their ownership of the business. However, …

Business owners will retain their ownership of the business if either of the following three conditions is true 

  • All “impaired” classes vote in favor of confirmation of the Plan, OR
  • Business owners contribute “new value” to the business which enhances creditors’ receipts under the Plan.

“Impaired Class” means its members will receive less than the amount owed to them.

“New value” is meaningful, and substantial monetary value contributed by the business owner(s) in cash, hard assets, debt forgiveness, or in some cases “sweat equity.” Local case law, rather than statutes or regulations, determines what is satisfactory “new value.” As a result, only your bankruptcy attorney can give you credible, reliable guidance regarding “new value,” and its application in your court district.

A “cram-down” of the Plan does not waive the Absolute Priority Rule. Cram-down occurs when the court confirms a Plan over the objections of one or more, or even all the impaired classes. The court will agree to a cram-down only if it determines the Plan to be fair, equitable, and non-discriminatory. Of course, the Plan must comply with all other confirmation requirements.

The “bottom line”

The owners in a (non-Subchapter V) Small Business Case filing need to incentivize all impaired creditor classes to vote in favor of the Plan. Otherwise, the owners will run afoul of the Absolute Priority Rule and may lose their business.

NOTE: Subsequent parts of this series will explain settling business debts for Classes I, II, and III. There is no separate part discussing Class IV – Equity Interest Holders. Instead, parts discussing the other classes integrate any implications and considerations for the business owners.

How can my business function if its property is foreclosed and its vehicles and equipment are repossessed?

The “Automatic Stay”

“Automatic Stay” is one of the most important benefits of filing for bankruptcy. It goes into effect immediately upon filing a petition for bankruptcy.

It provides immediate relief from creditors and collection agencies.

The Automatic Stay prohibits continued collection efforts and contact from creditors and collection agencies. Also, it prevents foreclosures, repossessions, seizures, evictions, and turning off utilities while the bankruptcy case is proceeding. Lawsuits brought by creditors are immediately suspended and no new debt-related legal actions can be brought against your business.

But the relief is only temporary.

However, the Automatic Stay “lifts” (ends) once a Plan of Reorganization is confirmed. It also lifts if the case is dismissed or denied by the court or converted to Chapter 7. 

But the relief is only temporary.When the Automatic Stay lifts …

Secured creditors can foreclose, repossess, or seize the property collateralizing the debt once the Automatic Stay lifts.

Likewise, holders of “executory contracts” and unexpired leases can evict debtors, or repossess the leased property (e.g., car, equipment, etc.) and pocket any security deposits.

(NOTE: If any collateralized property is not essential in the normal course of business, the secured creditor or executory contract holder can petition the court for exemption from the Automatic Stay. If granted, they can foreclose, repossess, or seize the property or evict the debtor from the premises without having to wait until Plan confirmation.)

What about my business’s co-signed debt?

The co-signed debt trap …

If ANY of your business’s loans, secured or unsecured, have a co-signer, be aware of the following:

  • If the court discharges any portion or all a co-signed debt, only the business’s liability is discharged. The co-signer remains personally liable for any portion of the debt that is discharged by the court. That means the creditor can sue the co-signer for any portion of the debt that was discharged by the court. This puts the co-signers’ personal assets at risk.
  • Chapter 11 only requires the debtor to pay the lesser of FMV or the outstanding debt to its secured creditors. The secured creditor can sue the co-signer for the difference if the FMV of the property is less than the outstanding debt.

Co-signed debts require special handling to protect the co-signer from incurring liability. Your bankruptcy attorney has dealt with this situation countless times and knows best how to achieve a favorable resolution.

It’s a fact. The creditor will incur significant legal fees to collect from the co-signer. Your bankruptcy attorney knows how to leverage this fact and negotiate a favorable settlement for your business and relieve the co-signer of fiscal responsibility.

How will I settle business debts under Chapter 11?

“Step-by-step” guidance

Subsequent Parts in this series provide step-by-step guidance for settling business debts with each class of creditors/claimants. Key topics include the following …

  • Code requirements for settling each class of creditors’ claims.
  • Your business’s options for addressing each class of debt.
  • How to choose among the options for addressing each class of debt
  • Credit-yogi.com’s free, downloadable Debt Resolution tools.
  • How to account for the budgetary impact of your debt resolution choices in your business’s Plan of Reorganization.
End of Part 3